How to Invest If You're Worried About a Stock Market Crash

It seems that every time I turn on a financial report, someone's warning that the bull market we've been enjoying for more than eight years is about to come crashing down. Some analysts point to signs such as the rising price of gold, decreased trading volume, and muted reaction to strong earnings reports as harbingers of a crash. Others just point to the calendar: Since 1926, the average bull market has lasted nine years, and ours by most measures is about eight and a half years old. (See also: Are We Headed Toward a Bull or Bear Market?)

While there is some truth to the notion that no party lasts forever, there is also no definitive way to predict when we might see a correction (a 10 percent decline) or a crash (a 20 percent or greater drop). So before we get into the nuts and bolts of market disaster preparedness, understand this: No matter how nervous people feel, a correction may not happen this year or even next. This is really important to know, because if you make drastic changes to your portfolio to protect it from stock declines, you may well miss out on months or even years of growth that you can never get back.

Does that mean you should plunge your head into the sand and do nothing, no matter how worried you feel about a possible market crash? No. There are steps you can take that would both set your mind at ease and help prepare your finances for whatever the market brings. (See also: Want Your Investments to Do Better? Stop Watching the News)

Take stock

Harness the energy of your market jitters to perform some portfolio hygiene that you should have been doing all along. If you've been carrying too much risk without even realizing it, now's the time to adjust that.

"Figure out what your allocation is between equities (stocks) and fixed income (bonds and cash)," recommends investment adviser Bob Goldman. "A lot of people will find they had a higher concentration of equities than they thought they did, because equities, especially U.S. equities, have done so well in the past few years."

How do you know if you're carrying the right amount of risk? It's all about your goals and your timeline. Riskier portfolios generally have a higher percentage of stocks and a lower percentage of bonds and cash. If you need your money to grow to meet your goals, you'll have to take on some risk to get there. If you're not sure how much risk you should take on, consider investing in a target date index fund, where you input when you need the money, and the fund manager does the rest.

If your portfolio is considered appropriate for your timeline but you just can't sleep at night, it's OK to dial back the risk to give yourself peace of mind — as long as you can afford to. Use an online investment calculator, consult portfolio allocation models, or talk to an adviser to figure out if you could reduce your stock allocation by 10 percent and still have enough money to retire when you want to. If you'll still have enough, then go ahead. (See also: 5 Essentials for Building a Profitable Portfolio)

Keep investing

If you have been contributing money from each paycheck to your 401(k) or buying stocks in a taxable account, don't stop just because you're worried the market may be peaking. Remember that if a bear market happens, it won't last forever. In fact, bear markets are almost always shorter than bull markets, with an average decline and recovery of just three years.

You may be tempted to slow down your investment schedule, dividing your money into periodic investments instead of buying stocks and bonds in one lump sum. This would save you some losses if a crash really does come during the year, but this approach, known as dollar cost averaging, usually doesn't pay off since timing the markets is typically considered futile.

So what if you buy today, and the market crashes tomorrow? By one expert calculation, in this worst case scenario, it takes an average three years to get the money back. If you are investing for the next 10 or 20 or 30 years, rest assured that even if the absolute worst happens, it will almost certainly work out in the long run.

Don't invest anything you'll need within five years

If a downturn happens, you don't want to be forced to sell and take a loss. This five-year rule is always a good one to follow, but if you believe that a downturn is coming, it's a great time to double check to make sure you have what you need for near-term spending in cash, CDs, or a money market fund.

What you "need" means different things to different people based on their situation. If you were planning to send your kid to college in two years, it means the first three years' tuition should not be in the market at this point. If practical, Goldman suggests keeping a two-year emergency fund, covering all your minimum expenses for that period. That way if a downturn snowballs into a recession and you lose your job, you'll still be OK. When making the calculation of how much you need, don't forget that you probably won't owe taxes or be making retirement contributions if your income goes away.

Consider saving up for bargain shopping

When stock prices crashed in 2007 and 2008, I had no money to invest. Warren Buffett did, though. One of Buffett's financial crisis investments was putting $5 billion into Goldman Sachs, a stake that increased in value by 62 percent within five years.

Probably no one reading this will ever be in the position to take advantage of a bear market to that extent. But it's not a terrible idea for investors to put aside a cache of cash earmarked for buying stocks in a downturn. Just remember not to short circuit your entire investing plan by putting all your money into that basket. As Buffett said in his most recent investor letter, investment gains and downturns will be "totally random as to timing." You don't want to put off investing for years waiting for a downturn that doesn't materialize.

Don't forget that five-year rule here, especially, because if you buy stocks that have just declined, you have no way of knowing if the price you pay is the bottom. You may be "catching a falling knife," meaning that the stock you buy may continue to plummet after you purchase it. But if what you bought is a diverse index fund, don't feel too bad if it keeps going down after you purchase. After all, within a few years, you should be gaining again.

Beware of salespeople who prey on fear

Stockbrokers and other sellers of investment products may take advantage of jittery investors to push vehicles that promise to limit downside, such as annuities, insurance policies, or even that old supposedly safe haven, gold.

Analyze all investment opportunities with a cool head. Find out what the seller has to gain by getting you to sign on. When in doubt, stick to investments that you understand well, or consult a fee-only planner with no stake in where you put your money.

"The end of bull markets, in my experience, are often signaled by the invention of esoteric and exotic investments that sound good but are really a mix of ordinary stocks and bonds mixed with leverage to give you 'enhanced' and 'select' returns," warned Mitch Goldberg, president of ClientFirst Strategy, in a CNBC commentary. "If you've recently put money, or been advised to put money, into an investment that is very narrow, or you simply don't understand, get out."

Avoid debt and leverage

One of the causes of the 1929 stock market crash was excessive leverage, which means that lots of investors were playing the market with borrowed money. Typically, brokerages will sell stocks to some investors "on margin," which means that the investment bank lends you the money to buy the stock, holding the stock as collateral. This is risky, because if the market price of your investment declines sharply, the bank can call in your loan, forcing you to sell at a loss.

Buying stock on margin can be considered reckless in the best of times. If you fear a correction is coming, getting rid of leverage is an obvious way to make your portfolio more conservative.

If you are able to pay down debt in other areas, such as car loans and credit card debt, this can also help strengthen your financial standing to help you weather any bad times that may lie ahead.

The other nice thing about paying down debt in an uncertain time is that it's a safe place to put your money. If you have a 4 percent interest rate on a loan, paying down that loan is like getting a guaranteed 4 percent return on your money. That's not a huge return, but if you are scared that you'll lose that money in the market, reducing your debt is a safer bet.

Keep it all in perspective

We may lose a lot of sleep worrying about a stock market crash without really knowing how such an event would affect us. Here's a little exercise that might help ease your mind: Look at your current portfolio, then cut 10 percent or 20 percent, or even 30 percent from the total. Then use an online investment calculator to figure out what the typical return would be on that money, if it was a new investment, over the course of your investment timeline. Can you live with the results?

Then remember that even if the market does drop 10 percent or 20 percent or even 30 percent, chances are the effect on your personal portfolio won't be as extreme.

"You have to remember, if you're diversified, and the U.S. stock market drops 30 percent, that doesn't mean everything else will drop," Goldman says. That's why you have a diversified portfolio containing international stocks, bonds, and other investments.

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